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Thursday, August 25, 2011

Buffett and Bank of America: Playing Poker with Patsies...

Warren Buffet is famously quoted as saying, "If you have been playing poker for half an hour and you still don't know who the patsy is, you're the patsy". Today, we got a glimpse of Buffett playing poker with Bank of America, and at least from my perspective, it seems clear who the patsy in this game is... it is either Bank of America's stockholders or the rest of us who attribute mystical properties (and uncommon ethics) to the Oracle from Omaha...

So, let's recap what happened. It has been a rough few months for Bank of America stock, prior to today. The stock price had halved between November and yesterday:

Macro factors (the Euro crisis and the S&P downgrade) did play a role in the price decline but the company had itself to blame as well. It reported a loss of $8.8 billion for the second quarter of 2011, reflecting payments to settle legal claims related to troubled mortgages.While the stock price decline suggested that the market was increasingly pessimistic about the company's future profitability, the company itself indicated that it was sufficiently capitalized to make it through these travails. Earlier this month, the company announced that it would lay off 3500 employees and cut costs, but evoked little positive response from the market.

Today, we woke up to the news story that Warren Buffett, white knight extraordinaire, had ridden to the rescue of Bank of America.

- Buffett invests $ 5 billion in preferred stock, with a 6% cumulative dividend, redeemable by the company at a 5% premium on face value.

- If Bank of America is unable to pay the preferred dividend, not only do the dividends cumulate but they do so at 8% per annum and the bank is restricted from paying dividends or buying back stock, in the meantime.

- Buffett get options to buy 700 million shares in BofA at $7.14/share, exercisable any time over the next 10 years.

Let's see what Buffett gets out of the deal. Valuing the options with a strike price of $7.14, even using yesterday's low price of $6.40/share, an annualized standard deviation of 50% in the stock price (significantly lower than the 3-year historical standard deviation of 79% and the implied standard deviation in excess of 100% from the option market) and a ten-year maturity, I estimate a value of $4.30/option or an overall value of approximately $ 3 billion (700*4.30) for the options. (I know.. I know.. Buffett does not like using the Black-Scholes model for long term options...Perhaps, he sold Bank of America's managers on the idea of using the famous Buffett-Munger long term option value model to derive a value of zero for these options...) Netting the $ 3 billion value of the options out of the $ 5 billion investment in the preferred stock makes it a $ 2 billion investment, on which $ 300 million is being paid in dividends. That works out to an effective dividend yield of 15% on the investment. By exercising his veto power over dividends and stock buybacks, Buffett can ensure that he is always the first person to be paid after debt holders in the firm. To cap it off, Berkshire Hathaway will be able to exclude 70% of the dividends received from Bank of America in computing taxable income (this is the rule with inter-company dividends), when paying taxes next year. That is an incredibly sweet deal!

What did Bank of America get out of this deal? Let's look at what it did not get first:

It did not get Tier 1 capital (the most stringent measure of bank capital), which includes only common equity, and thus does not get any stronger on that dimension. (Update: I have been getting mixed responses on this issue from those who are well versed in bank regulatory capital rules, some saying that I am right and others that I am wrong. The fact that it is cumulative preferred stock, according to some, makes it ineligible for Tier 1 capital, whereas others note that Citi was allowed in 2008 to count cumulative preferred as Tier 1. Here is one article that seems to provide clarity on the topic. My final response. Whether this passes the regulatory rule requirement or not, it does not pass the common sense rule for Tier 1 capital. If financing results in a commitment of $ 300 million each year that you have to meet, or roll over, it cannot be true Tier 1 capital, no matter what the rules say... )

It gets no tax deductions, since preferred dividends are not tax deductible. So, the $ 300 million in dividends will have to be paid out of after-tax income.

It risks losing flexibility on dividend policy and stock buybacks, as a consequence of the restrictions imposed on this deal.

The only conceivable benefit I see accruing from this transaction to the company is that Buffett has provided some cover for the managers of Bank of America to make two arguments: that the bank is not in immediate financial trouble and that it is, in fact, a well managed bank. I, for one, am not willing to accept Buffett's investment (or his words) as proof of either, and the way the deal is structured is not consistent with any of the arguments I have been hearing all day (from those who think it is good for Bank of America stockholders).

First, let us assume that the bank is not in financial trouble and that the market has run away with its fears over the last few months. But, why would a bank that is not on the verge of collapse agree to raising capital at an after-tax rate of 15% and give up power over its dividend and buyback policy? And given the extremely generous terms offered to Buffett on this deal, how can this action be viewed as an indicator of good management?

Playing devil's advocate, let's look at the other possibility, which is that the bank has been hiding its problems and is in far worse shape than the rest of us think. If so, perhaps the terms of the deal make sense to Buffett (high risk/high return), but the deal still does not make sense to Bank of America. If the bank is in that much trouble, it should be raising tier 1 capital, and adding $ 300 million in preferred dividends to its required payments each year makes no sense. And, if it is in fact the case that the bank is in a lot more trouble that we thought, how can Buffett in good conscience then claim that BofA is a "strong, well-led company"?

Either the terms of deal are way too favorable to Mr. Buffett or he is not being forthright in his description of the company... In either case, this does not pass the smell test.

I know that there are some who are comparing Buffett's deal with Bank of America to his earlier deal with Goldman Sachs. But there is a key difference. The Goldman deal was entered into at the depths of the banking crisis, and in a period where liquidity had dried up, Buffett was providing capital. Even in that case, you could argue that Goldman Sachs paid a hefty price for taking money from Buffett to shore up their standing... Perhaps, this has become Buffett's competitive advantage. Rather than buy and hold under valued companies, which is what he used to do, he focuses on companies that have lost credibility and he sells them his credibility at a hefty price. I know that Buffett has accumulated a great deal of trust with investors over the decades, but even his stock will run dry at some point in time, especially if he keeps dissembling after each intervention about the company, its management and his own motives.

In summary, is this deal good for Buffett? Absolutely, and I don't begrudge him any money he makes on this deal or the fact that the tax law may work in his favor. Does the deal make sense to Bank of America's stockholders? I don't think so, notwithstanding some of the cheerleading you are hearing from some equity research analysts and the market's positive reaction. Is Bank of America a "strong, well-led" company? Only if you have a very perverse definition of strong and well-led...

60 comments:

I could not have agreed more. If Buffet was indeed confident of BAC financial health and management, he would have invested in common stock. Also, as far as equity research analysts are concerned how did valuation change by 10% just by the injection of preferred equity? The only take away for BAC's management is that they have managed to kick the can down the road.

Agree completely..seems very strange that a $75 billion market cap company, that claims they are well capitalized, would raise $5 billion at a 15% cost of capital..maybe higher, considering you were kind to BAC on your option value calc.

Couldn’t have agreed more with “Rather than buy and hold under valued companies, which is what he used to do, he focuses on companies that have lost credibility and he sells them his credibility at a hefty price.” Would BAC have offered the same deal to an unknown investor? I don’t think so.

Additionally, in your "what does B of A get from the deal" you missed probably the most important point: they will glean savings from lower funding costs in rolling over close $100 billion in debt over the next couple of years. The author in the link above estimates these savings around $1.4 billion - roughly equal to the discount Buffett received on the deal.

I did read that piece. I am not as sure as the author of that piece that this will count as Tier 1 capital -that is determination that will have to be made by the regulatory authorities and the specifics in this case are murky. As for the savings in rolled over costs, let's not talk about illusions.. Are you telling me that lenders to BofA two years from now will remember this investment and forget about fundamentals? I don't think so...This is a turkey, from the viewpoint of BofA stockholders. Dressing it up will make it a well-dressed turkey, but it will remain a turkey.

Aswath, your valuation ignores the fact that the prefs were sold well below market. People (media) look to you for valuation expertise and your 15% yield is very misleading. At least note the oversight.

In the article you link to, the author makes the same error highlighted in the link from my original comment.

Namely "since the preferreds are cumulative, starting in 2013, they will not count as Tier 1 capital."

Cumulative is not the appropriate measuring stick.

"Are you telling me that lenders to BofA two years from now will remember this investment and forget about fundamentals?" "This is a turkey, from the viewpoint of BofA stockholders."

If you are going to use vague platitudes that cannot be verified/confirmed/denied, then I will play along: If the deal is such a turkey for holders of the common, then why is it up ~10% since the announcement?

Finally, like Simon Moody, I beseech you to acknowledge your oversight of the preferred's being issued will below market.

Simon Moody & WSM, why the long face? you can disagree with Damodaran on BoA but your unwarranted aggression on an opinion blog hints at sparkles of inferiority complex. if you are so inclined why don't you do your own analysis and post it wherever you wish; see if anyone reads it.

I am impressed that you are able to predict that this safely meets Tier 1 capital requirements, because here is what I found from the FDIC:http://www.fdic.gov/regulations/examinations/supervisory/insights/siwin10/trust.htmlThe preferred that the FDIC is counting in Tier 1 is cumulative, trust preferred stock. None of the descriptions of the Buffett preferred have characterized it as trust preferred. If so, it may meet the requirements for Tier 1. Even if it does, it makes no sense.As for Simon's point, I don't get it. It was issued at a discount? To whom? To Buffett? That would make it worse.... Perhaps, I am misunderstanding your point.As for savings on future bond issues, you have to make up your mind on whether BofA is a healthy bank, beset by speculators who have created imaginary risks for the firm, or it is not a bank with significant problems. If it is the former, why is it raising new capital at 15, 16 or 17%? If it is the latter, this confidence booster will fade as the toxic assets from Countrywide come to the surface.

Fair enough - obviously I cannot tell the future and do not know whether this deal will ultimately be given Tier-1 status. But I have not seen any accurate arguments convincing me that it will not be Tier 1.

"Even if it does, it makes no sense."

WHAT makes no sense?

"It was issued at a discount? To whom?"

It was issued at a discount to BofA! Market rates for such a security are closer to 9%.

"As for savings on future bond issues, you have to make up your mind on whether BofA is a healthy bank, beset by speculators who have created imaginary risks for the firm, or it is not a bank with significant problems."

This is a false dichotomy. In fact, there are other options. Namely, it IS a bank with significant problems. And it can be argued that, at this price, those problems are priced in.

Said problems will likely take the better part of decade to take their toll. In other words, there is a higher probability of the problems manifesting via drawn out legal proceedings, political can-kicking (failure to eliminate mark-to-model accounting), etc... rather than a one-time event that will explode the company in any single quarter.

That is the 'discount' argument? I am sorry but that comparison makes no sense. The preferred stock that yields 9% does not come with an option kicker; this one does, pushing the yield up to 15% or higher.

As for the second part of the argument, we will have to agree to disagree. If BofA does have significant problems, how is the Buffett investment making that much of a difference? By giving BofA more breathing room? That may help.. but only if the problems are fixable over time.

They are part of the same deal and not separable. Exactly... That is why the true yield on this preferred is 15% or higher.. Buffett invests $ 5 billion and gets options worth $ 3 billion thrown in for free. He makes $ 300 million a year. The stated yield on this preferred stock is worse than meaningless. It is completely misleading.

Many thanks for your valuation presented here! Was interesting to read.

As for me, i suppose that the deal lies more in the field of signaling to market that BoA is OK and fine, rather then having some common sense in it from the side of valuation. We all know the popularity of Buffett and his long accumulated credibility in the area of a well-done investments - a credibility he can share with firms in times of their need. Being another target in Buffett's successful track record of investments (at least potentially successful), may calm the markets a bit and give BoA what they need... However i totally agree with, that the price BoA paid for it is really big and and as that price may have adverse effect on the markets. It is OK if you sell to Buffett for a good price to your shareholders (with some minor discount, as it's Buffett after all!), but it's not that well when you actually give that much money to Buffett - and the market may see it one day!

By receiving a good deal with great pricing, Buffett is ensuring his reputation of Omaha Oracle, as even in case of BoA turmoil, the deal will be great for him based on valuation you sir provided here! BoA on ther hand receives a great portion of PR and ability to attract Tier-1 capital at cheaper price (at least i hope that Buffett may help on this).

I think the deal is structured this way (through pref + warrants) to show that BAC truly does not need capital. A direct investment in common stock would send a big signal to the market that BAC needs more capital. And the fact that BAC didn't go out to raise more equity capital (like Goldman did in 2008) along with Buffett's investment also showed that BAC has adequate capital. Also the investment is a big boost to employees' morale (I read news about cheers in BAC offices). I think it's a win-win transaction. For BAC, the Buffett's investment helped reverse market perception that their rep and warranties and other legal liabilities will wipe out equity holders and by the look of their CDS, bondholders were getting worried that they will be hit. For Buffett, it's an investment that reminded him of his American Express salad oil scandal invesment in the 60s and his Geico investment in the 70s.

I believe that the 'premium' that is paid by Bank of America in this deal is attributable to the credibility that Buffet has. He took advantage of the crisis that BAC is going through and structured a deal that seems sweet to him, at least if you look at it from the risk/reward ratio.As for the management of BAC, they probably wanted to stop the sharp decline in the company's stock price. Today's stock price decline can mean tomorrow's depositors' run on the bank...

Where I struggle with your valuation is that you net the $3bn options against the $5bn face value of the pref. You are making the assumption that the prefs have a value of $5bn (or equal to the face value). I would argue that if you discount the cash flow associated with the pref then you would come up with a value materially less than $5bn.

I don't think that the prefs are worth more because they come with the options ("equity kicker"). We have agreed to value the options separately and if you reduce the discount rate on the pref because of the kicker then you are double counting the value of the options.

Simon,The $ 5 billion is not an estimated value. That is how much cash Buffett is paying to BofA to get the preferred. The $ 300 million in dividends is not an estimated value; it is the stated dividend yield on the $ 5 billion. The $ 3 billion for the options is an estimated value, but I think it is a conservative estimate.

Michael,With long term American options, it is true that the Black Scholes model. I agree that assuming that the variance will not change for 10 years is a significant assumption, but you could actually back out an implied variance from LEAPs (long term options) on BofA that yield variances much higher than 50%.. So, that is why I characterize my valuation as conservative.

Aswath, you keep quoting the face value of the pref as it's fundamental value. Buffett could not sell that pref today for $5bn therefore the fundamental value is lower. If you think someone would pay five billion then your work is correct. But there is zero chance the market would pay par value for a BAC pref security yielding 6%. He paid five billion for a preferred security that has a fundamental value closer to four billion (rounded estimate). You need to account for that missing one billion in your valuation.

Simon,I think you are over thinking this. It is irrelevant what he can sell the preferred for today. Think cash in and cash out. Buffett today is investing $ 5 billion in cash into Bank of America and he is receiving options for free. He will receive $ 300 million in dividends each year. The only real debate is what the value of the options are... there is none about the cash in and cash out. If he had received no options, the preferred dividend yield would be 6% based on his investment (which is all that matters, not what he can sell the the stock for today). If the options have value, he is effectively investing less.

Aswath, on a cash in vs cash out basis Buffett is earning a 6% cash yield. As soon as you take the value of the options into consideration then you need to consider the value of the preferred (which is not equal to the face value) as you are attempting to show what his yield is on the bases of the value of the securities he has received.

Your analysis fails to provide any insight into the terms of the pref and its fundamental value. For example, if the prefs had terms that allowed Buffett to force BAC to repurchase the securities at 120 (an unrealistically good term for Buffett) then the pref would be worth more than five billion or par and BAC would have been very desperate. In reality, the terms are less favorable than market and these prefs will trade down below par.

I understand the point of your analysis but it is a simplistic way to evaluate the deal.

Simon,Let me reframe the analysis on your terms. Let me accept your premise that the preferred is really worth only $ 4 billion (because the fair preferred dividend yield is 9%)... Therefore, Buffett is losing $ 1 billion on the preferred stock. He is, however, getting $ 3 billion of options for free. Net, he is getting $ 2 billion from Bank of America for providing his credibility.That is exactly my analysis would have concluded as well. I estimated the net investment that he made in the preferred stock to be $ 2 billion ($ 5 billion minus $ 3 billion in options). That is a discount on the fair value of $ 4 billion.The real question then becomes whether $ 2 billion is a fair price to pay for the credibility that is being acquired. On that question, there can clearly be differences of opinion. I can see a scenario where the $ 2 billion allow Bank of America enough breathing room to survive and return to health... My only point then is that Buffett is not being entirely truthful when he calls the firm a "healthy, well-run firm".

Aswath, I could not agree with you more. This is a sick company that is raising distress capital. It will be intersting to watch the write downs over the next few quarters as you can bet there are some big ones to come.

Aswath,Isn’t it a bit simplistic to say that either BOA is a healthy, well-run firm, in which case it does not need Buffets investment, or else it is a firm with deep fundamental problems, and thus not healthy or well-run?

Can’t a bank be both healthy and well-run but nevertheless run into problems? An example; the stock price falls leading CSD spreads to widen which again leads to more rumors of trouble, the stock price falls further, CDS spread widen… You get a downward and self reinforcing spiral that have actual negative impact on the firm and thus in the end can make it go belly up.

By breaking this negative spiral Buffet creates actual value and the deal could be a win win for Buffet and BOA if the value created is larger than the 2bn you have calculated as the value to Buffet.

Anyway, I don’t think the statement “Buffett is not being entirely truthful when he calls the firm a "healthy, well-run firm".”, is necessarily true.

Aswath,This is an excellent piece of work. Thank you for taking time to do the analysis. I posted an article on the subject too, but did not have all information about the deal at hand. Major conclusions are the same, nonetheless.Do not rush to buy when Buffett 'invests'

Well, there is something else that Buffet has got out of this deal which nobody has yet talked about here. Now, Buffet can sell call options of strike price higher than $ 7.14, month after month and collect the premium which would be huge annual yield, without any risk because he can always buy the stock at 7.14. If stock price remains below strike price, he is making money. If price goes above and option gets exercised he would make even more money (strike price - 7.14+ premium).

Prof. Damodaran, if your latest comment is in reply to sandeep's, I don't see how it matters if buffett's warrants are not tradable but only hold-or-exercise -- they can still be used as the basis for a diagonal strategy as sandeep says. Write short-term OTM calls, which are naked in terms of the writer not owning the underlying but are in fact covered by the longer-duration, lower-strike warrants; if BAC soars to the point of not making it feasible or profitable to roll the short-term written calls forward or forward and up, then close the position for profit (the upside being limited by the written calls but positive).

Whether the income-oriented "diagonal spread" is preferable to just holding the warrants until (maybe) they're worth exercising, depends on the underlying thesis on BAC -- diagonalizing works better if BAC goes down, stays flat, or grows modestly over a given time slice -- it loses upside if BAC suddenly and violently swings upwards (the latter may not sound likely but, hey, equal probabilities of sharp corrections and sharp rallies is implied in Black-Scholes, no?-).

gindI was going to comment exactly what Alex said, but in less academical terms. He can basically employ a strategy in which he is hedged. We shouldn't forget that by selling the call options he gives up the upside of price appreciation that was already considered in valuing the options by prof Damondaran. In a perfect world the stream of premiums colected plus the gain when they get called should be equal to the value of the options themselves. So basically I don't think that we should consider that value IN ADDITION to what was calculated.

Anybody who is into options trading can easily understand that it is a simple covered call writing strategy. And possibility of such strategies is not taken into account by BS model while valuing options. So, buffet can still collect premiums easily. Infact, such strategies were in use by certain highly successful low risk hedge funds in 90s as mentioned in the book 'Market wizards' by jack schwager. For the record, rite now BAC is quoting at 6.99 and september series call (strike 9) is traded @ 2.00 $. So, as I said huge return, no risk, coz I dont see that BAC can go beyond 9 $ within 10 days.

Prof. Damodran, I have got your point. but if you could plz tell me some link or book where i can read in detail about pricing in the future premiums of higher strikes. Not able to find anything on this neither in John C Hull nor web.

I don't fully understand this article or calculations to come up with 4.80/option value. What I do think is that Buffet bought Goldman shares at $120 and the stock fell all the way down to I think 47 or so before rebounding. I wouldn't be shocked to see BAC @ around 3 bucks at some point. This calculation should be a lot easier to understand. However, if things aren't as bad as they were back couple of years ago, then let's just throw in another buck. Hence, according to my very sophisticated calculation BONK of American is a BUY at 4 bucks a share.

Options Trading business also gives you an extra benefits the way you expose your investment to risk. Factors that can affect the risk of an option position include asset price, volatility, time, and interest rates.

Very thoughtful critique! One question...isn't there an implied option for BAC to redeem the shares at a 5% premium? If so, that should be added back to the net $2B price tag you calculated.

Excellent point about tax leverage Buffet is applying. It rather flies in the face of his declared idea of "tax fairness". Has anyone done a study on the tax advantage (e.g. dividend, capital gains, others?) Buffet's BRK has leveraged to achieve it's / his billions? I suspect we would not today be talking about the great investor named Buffet if he had to live under the burden of taxation he is a proponent of today.

Amazing analysis and counterpoints which clarifies a lot of things on this deal and how or why which side won lost etc . Currently BAC is around $11 and who knows in next 4 years where it goes. But one thing is certain Buffet or BAC either of them are not stupid to agree on a term just as Goldman/GE was Not stupid when it accepted the Buffet Deals . As about most comments here were of such short term thinking (ie thinking that BAC will go down NOW or in next 1 months) that it just does not make sense . Most of people know Buffet is not going to sell these things quickly in 1-3 years . I piggy backed him . I have doubled my money . Hows that for a change . If anybody really kind of disagrees with Buffett Investments just go and short the stock and watch the fun. When there is NO money going out from your on pocket we can debate morning till evening. How about actually going against buffet by putting your money on the line and debating against his investments ?

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